Case: THE BOND INVESTMENT DECISIONS OF DAVE AND MARY CARTER
Dave and Mary Carter have a successful dental practice. They have built up a sizeable investment portfolio and have always had a major portion of their investments in fixedincome securities. They adhere to a fairly aggressive investment posture and actively go after both attractive current income and substantial capital gains. Assume that it is now 2010 and Mary is currently evaluating two investment decisions: one involves an addition to their portfolio, the other a revision to it. The Carters' first investment decision involves a short-term trading opportunity. In particular, Mary has a chance to buy a 7.5%, 25-year bond that is currently priced at $852 to yield 9%; she feels that in two years the promised yield of the issue should drop to 8%. The second is a bond swap. The Carters hold some Beta Corporation 7%, 2023 bonds that are currently priced at $785. They want to improve both current income and yield-to-maturity, and are considering one of three issues as a possible swap candidate:
(a) Floss Ltd, 7.5%, 2035, currently priced at $780,
(b) Canal Products, 6.5%, 2023, selling at $885, and
(c) City Insurance, 8%, 2024, priced at $950.
All of the swap candidates are of comparable quality and have comparable issue characteristics.
QUESTIONS:
1. Regarding the short-term trading opportunity:
a. What basic trading principle is involved in this situation?
b. If Mary's expectations are correct, what will the price of this bond be in two years?
c. What is the expected return on this investment?
d. Should this investment be made? Why?
2. Regarding the bond swap opportunity:
a. Compute the current yield and the promised yield (use semi-annual compounding) for the bond the Carters currently hold and for each of the three swap candidates.
b. Do any of the three swap candidates provide better current income and/or current yield than the Beta Corporation bonds the Carters now hold? If so, which one(s)?
c. Do you see any reason why Mary should switch from her present bond holding into one of the other three issues? If so, which swap candidate would be the best choice? Why?